Friday, 29 March 2019

Will Brexit make austerity worse?

There seems to be
some confusion among some on the left about the impact of Brexit.
Statements like ‘Brexit will make austerity worse’ by Remainers
are imprecise, so let me spell this out. Because of the
controversy this generates I’m afraid this is going to be a rather
dry, analytical post. But if you think government spending
can somehow reverse the negative economic impacts of Brexit, this
post is for you.

Brexit will reduce
UK trade relative to what it would be if we stayed in the EU. How much will depend on the type of Brexit. As I outlined
here,
it will not be possible to come near to replacing that trade through
new trade deals. So less trade is a given.

Less trade reduces
GDP mainly because it reduces productivity. Trade allows
specialisation. Instead of Honda cars being produced in each EU
country they can be made in just one, which allows (in part because
of what economists call economies of scale) the cars to be produced
more efficiently. Trade also increases competition (you can buy many
makes of car in the UK) which improves efficiency. Therefore if you
restrict trade, you reduce productivity. Less productivity means less
GDP. I discussed how much GDP could fall under May’s preferred
trade arrangement here.

A reduction in
productivity is a supply side decline in GDP. It is very different
from a demand deficient recession of the kind we had after the GFC.
In a demand deficit recession fiscal policy (more government spending
or lower taxes) can be used to restore demand and therefore GDP, and
must be used if interest rates are stuck at their lower bound. The
tragedy of austerity from 2010 is that the opposite was done. The
decline in GDP brought about by lower productivity following less
trade cannot be tackled in that way.

When GDP falls,
taxes fall. To keep the deficit constant, that requires a reduction
in government spending. Brexit will reduce government spending
compared to what it would be if we stayed in the EU. To that extent
Brexit makes austerity worse. To say that those who point this out
are advocating a continuation of the policy of 2010 austerity
are wrong.

It is important to
note that what I am doing here is comparing two states of the
economy, and saying what the differences would be between those two
states. This type of comparison confuses many people. I am not saying
government spending is going to be lower than it is now - it almost
certainly will not be. People say cannot we do something to mitigate
the impact on GDP of Brexit? There are many things that can be done
to improve GDP, like more public investment, but they could also be
done if we stayed in the EU. If you think there is still spare
capacity in the economy then GDP can be raised by fiscal or monetary
policy, but that is equally true in or out of the EU.

Does government
spending have to lower out of the EU compared to inside the EU? The
answer is no, which is why statements like Brexit will make austerity
worse are incomplete. You could keep government spending at the same
level in and outside the EU. But that would raise the deficit, which
requires higher taxes. So in that case Brexit would increase taxes.
So a correct statement would be that Brexit either reduces government
spending or raises taxes or some combination of the two.

At this point you
get MMTers up in arms. The deficit does not matter for a country with
its own currency and so on. Or even worse, that government spending
determines taxes and not the other way around. This is a very good
illustration of how misleading MMT rhetoric can be. To see why, go
back to the case where government spending falls in proportion to GDP
under Brexit, which means the deficit is unaffected by Brexit. Now
suppose you increased government spending to the level it would have
been without Brexit. That is an expansionary fiscal policy, which
stimulates demand which raises inflation. The obvious way to reduce
demand and inflation is to raise taxes so the deficit is back to its
original level. It does not matter whether you need to keep the
deficit unchanged because you have a fiscal rule, or you have fiscal
policy stabilising the economy as MMT advocates, you get the same
result.

Some MMT followers
never admit they are wrong, so I got a lot of stuff about how you can
use other measures to reduce inflation like credit controls. But you
could use them if we stayed in the EU as well to allow higher
government spending or less taxes. There is no obvious reason why
leaving the EU makes such measure more effective.

The correct
statement about the impact of Brexit on the public finances is that
it means government spending will be lower or taxes higher or some
combination of the two. Furthermore the overwhelming majority of
economists think GDP will fall as a result of Brexit, and I have not
come across an academic whose field is trade economics who thinks
otherwise. If you think, as I do, that this government has reduced
public spending way beyond the level that people want, and therefore
you want to raise that spending, Brexit makes that more difficult.
.

5 comments:

I agree with a lot of this, what I think has raised a lot of hackles on the left and certainly for me personally is the talk of the idea that in the event of Brexit, austerity is an inevitability. I remember such talk around 2009/10 and it was nonsense then and I really have no desire to repeat it and no desire to see the Tories use such rhetoric to further their state shrinking agenda.

My view on the last period of austerity we had is that as well as the obvious consequences of cuts, it has fed back into the supply side of the economy limiting the economy's capacity. I still don't think we're really off the ZLB and I think engaging in a further period of austerity justified by Brexit is just about the worst of all possible worlds.

Granted, scope for fiscal expansion would be less under Brexit but I think that talk of cuts being inevitable under Brexit is bad in too many ways to count.

The best FT chart was the one showing a positive rather than a negative correlation between a region's dependence on exports to the EU and voting leave - yes POSITIVE, not negative. It's not a straightforward matter......

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